Why Worry about Mutual Fund Selection?
Selecting the best mutual fund investment depends on your investment objectives. One helpful way to think through your objectives is to consider your time horizon: how soon after investing will you need to pull your money out of the mutual fund? Your time horizon also impacts the risk level of your investments. Most mutual funds can be organized into three broad categories: short-term, medium term and long-term. Before you make any investments in mutual funds, make sure you understand each fund's fees, management expense ratio and restrictions.
Mutual Funds For The Short Term
For purposes of investing, the best mutual funds investment for the short term are those that have no restrictions and focus on very low risk investments. In this section, short-term investing is taken to mean a year or less which allows for very little time to recover from losses. To evaluate whether a given mutual fund is suitable for short-term investing, consider two key factors:
- Holdings: Mutual funds that are mandated to hold only U.S. government bonds, such as T-Bills are well worth considering for short-term investing. Bonds issued by the governments of Canada, Japan, Germany, and the United Kingdom are also considered very low risk. If possible, look for a mutual fund that specializes in short-term bonds. For short-term investors that can bear a higher level of risk, consider a money market mutual fund.
- Mutual Fund Fees and Restrictions: Beyond the content of the fund itself, check the fine print to see if there are any penalties for selling your mutual fund in a few months. After reading the mutual funds agreement, ask the sales representative further questions about early redemptions to make sure you understand the agreement.
Muutal Funds For the Medium Term
Medium term mutual funds are typically used by investors who do not need access to their money for one to five years. Since this time horizon leaves limited time to recover from a market downturn, caution has to remain a factor. Unlike short term investors, medium term investors can invest in mutual funds with significant stock market exposure. Here are some criteria you can use to select a mutual fund for a medium term investment.
- Balanced Funds: Balanced mutual funds generally combine bonds and stock holdings. The combination of both types of securities provides for moderate growth potential while limiting the decline one can experience. The combinations offered in such funds can vary, but 50/50 or 60/40 (i.e. 60% stocks, 40% bonds) are typical. Unfortunately, the complexity of managing this type of fund can mean higher management costs.
- Dividend Mutual Funds: Mutual funds that focus on companies with a long history of paying dividends, such as those on those on the S&P 500 Dividend Aristocrats, will do well. The investment return for large companies such as AT&T and 3M will typically be at least 1-4% due to dividend payments. Mutual funds that specialize on large dividend paying companies are sometimes called "dividend funds" or "dividend growth"; the exact name will vary from company to company.
Mutual Funds For the Long Term
Long term mutual fund investors are typically saving for retirement and do not expect to need their money back for ten, twenty or even thirty years. Investments of this nature are a good choice for 401 (k) accounts and Roth IRAs, specialized accounts used to save for retirement. The longer time horizon for this type of investment also means that investors can afford to take on a higher levels of risk. As discussed in the previous sections, read the fine print and make sure you understand the fund's fees: high management fees need to be considered carefully.
- Geography: Many U.S. investors naturally prefer to invest in American stocks and investments. However, being overly concentrated in one country increases your investment risks. Long term investors should hold funds that cover both the developed world and emerging markets such as China, Brazil, India and Russia. In the long-term, developing countries are expected to grow substantially and that growth should be reflected in the local stock markets.
- Sector: Consider mutual funds that focus on alternative energy, bio-technology and other research and technology intensive sectors of the economy. The potential for growth in those sectors is considerable and long-term investors can afford to take on some exposure to these parts of the economy.
- Equity: Long term mutual fund investors tend to emphasize stock investments over bonds; the majority of a long term investment should be in equities. Some investments in bond funds (e.g. 10-30% of a portfolio) is generally recommended as a way to limit risk.
Now that you have learned about the best mutual funds investment for different time horizons, you are ready to continue your investment education. The resources provided in this section will assist you in continuing your research.
- Asset Allocation Models, https://www.aaii.com/asset-allocation
- Best Short-Term Bond Funds, https://money.usnews.com/funds/lists/fund-category-short-term-bond
- Image Credit: U.S. Savings Bonds, https://www.justice.gov/jmd/ps/empsbonds.htm